Raise the conforming loan limit to produce more entry-level homes in California

The down payment barrier inhibits home sales, but reduces the risk to the US taxpayer.

California endures a housing affordability problem. And it’s not merely that house prices are high. Families with high wages could finance mortgages large enough to buy more expensive properties, but they face another roadblock: the down payment barrier.

This problem is illustrated below. In Orange County, the conforming loan limit on GSE loans and the FHA loan limit is $625,500. For purposes of this illustration, I used the 3.5% down required on FHA loans because the 3% down program at the GSEs isn’t widely used due to the high cost of private mortgage insurance.

An FHA borrower in Orange County can buy a home for $647,392 and use exactly 3.5% down, or $21,892, a paltry sum given the purchase price. However, every dollar of the next $134,482 must come out of the buyer’s savings. In order to borrow $625,501, the borrower must use a jumbo loan, and that generally means 20% down, which translates to a $781,875 purchase price.

Needless to say, many more people possess $21,892 in savings rather than $156,375. This makes the market for properties priced above the conforming limit very thin and mostly unavailable to first-time homebuyers. It should surprise no one that housing inventory abounds on the MLS just above the conforming loan limit and both new home sales and resales are weak at higher price points.

The hard cap on FHA and GSE loans means borrowers must use a jumbo loan. Lenders who originate jumbo loans have stricter standards than the FHA or the GSEs, and most importantly, they generally require 20% down.

Many potential homebuyers who have the income to qualify for loans much larger than the conforming limit fail to obtain these loans because they lack the down payment.

This barrier is a particular problem to homebuilders in the Inland Empire where the FHA loan limit is only $356,500. It’s nearly impossible to build a house profitably out there given the high fees and other costs. Even if the land residual were near zero, it would still be a challenge to build and sell for less than $370,000.

Why isn’t the FHA/Conforming loan limit higher?

The dramatic increase in down payment requirements occurs at the FHA loan limit, and the low conforming loan limit inhibits sales. Therefore, everyone in the homebuilding and development industries in California wants a higher loan limit. Though this seems like a problem of mortgage finance, it directly impacts new home sales, development parcel sales, and residual land values. If buyers can’t buy, builders won’t build, and land developers and owners can’t sell their properties as quickly as they would like for an amount they want.

Through the lobbying efforts by the National Association of Homebuilders or the National Association of Realtors, Congress knows exactly how the conforming loan limit impacts home sales and new home development.

I recently spoke with Scott Meyer and Michelle Hamecs of the NAHB. They provided me their NAHB Issues Update that detailed the FHA loan limit issue (click here for that document). It isn’t ignorance to the problems the prevents Congress from raising the limit.

The conforming loan limit demonstrates the tug-of-war between two conflicting desires of policymakers.

On one side, advocates for the housing industry and advocates for expanded housing opportunities to all Americans want to push the loan limit higher. On the other side, the more fiscally conservative lawmakers want to lower the limit to restore the prior mandate of insuring loans only for lower- and middle-income Americans. Further, they want to reduce the potential liability for the US taxpayer, who would currently cover all the losses if the market crashes again.

If the conforming loan limit were reduced, it would decrease the potential liability for taxpayers and reduce the size of the GSE operations and make it easier to someday dismantle them; however, the last time the conforming limit was dropped, Irvine, CA witnessed an 84% decline in sales volume in the price range no longer financeable with GSE loans. Ouch!

So what is being done to solve this problem?

While the NAHB and NAR gallantly strive to educate Congress on the perils to the homebuilding industry, their efforts fail to persuade Congress to act. It’s a philosophical barrier they can’t overcome with reason or statistics. The fiscal conservatives in the House of Representatives simply won’t consider any legislation that will increase the exposure of the US taxpayer to future losses.

Fannie Mae, Freddie Mac, Ginnie Mae, the VA, and the FHA all carry the explicit backing of the US government. Each of those entities provides insurance for loans under the conforming limit, and if they go bust, the US taxpayer will cover the losses. For that reason, these lawmakers would rather reduce the footprint of these entities rather than increase it – irrespective of the consequences this may have to the California homebuilding and development industries.

Many industry professionals also hoped the FHA would adjust the loan limits by sub-areas within counties to reflect the diversity of markets. The FHA had the statutory authority from 2008-2011 and didn’t exercise it. The authority lapsed, and the FHA shows no interest in regaining or using this authority.

The good news for the industry is that the conforming loan limit is likely to go up slightly next year. The formulas used by the FHFA to calculate this limit signal a small increase, but not the large hike needed to produce entry-level homes under the limit. Any increase will help, but this move won’t spark a huge increase in production of entry-level homes in California.

What’s really needed is a return of private capital to residential lending, particularly lending on second mortgages to supplement the lack of down payment savings among first-time homebuyers. Part of the reluctance of lenders is due to the terrible losses they endured on these loans during the bust, but part of their reluctance is also due to the unresolved issues of mortgage finance reform.

The Fannie Mae and Freddie Mac conservatorship began in 2008. Eight years later, legislators find no consensus on how to remove, replace or release them. Until this issue is tackled, private lending will be hesitant to underwrite riskier second mortgages. The NAHB representatives were hopeful that 2017 may see activity on this issue, but I’m not holding my breath.

For the foreseeable future, don’t expect government-backed finance to come to the rescue of California new home sales.